23 September 2021 by Tax & Exchange Control Alert

Clarifying the interaction between provisions dealing with cessation of residency and the participation exemption

Constraints on revenue collection as a result of the COVID-19 pandemic have led to the South African Revenue Service (SARS) adopting a more robust approach to revenue collection, placing greater scrutiny on those taxpayers utilising intricate tax planning structures.

In the 2020 National Budget Speech delivered by the Minister of Finance, changes were announced to tackle a loophole exploited by a number of taxpayers relating to the interaction between the rules around:

  • taxing capital gains in the hands of South African tax resident shareholders on the disposal of shares in a South African company, as contemplated in section 9H of the Income Tax Act 58 of 1962 (Act).
  • providing a participation exemption from capital gains tax on the disposal of equity shares held by a South African tax resident holding at least 10% of the equity shares and voting rights in a foreign company, as contemplated in paragraph 64B of the Eighth Schedule to the Act.

Section 9H of the Act provides that when a South African tax resident company changes its tax residency to another tax jurisdiction, that company ceases to be tax resident for South African income tax purposes. The cessation of South African tax residence is deemed to be a disposal for capital gains tax purposes and triggers capital gains tax. The company is also deemed to have declared and paid a dividend in specie on the day before it ceased to be a resident – however, this deemed dividend may qualify for a dividends tax exemption under section 64FA.

Participation exemption

Section 10B(2) of the Act exempts foreign dividends from income tax if the shareholder, being a South African resident, holds at least 10% of the total equity shares and voting rights in the foreign company declaring a foreign dividend. This is commonly referred to as the “participation exemption”. The policy rationale for the participation exemption is to encourage capital inflows and to provide an incentive for South African tax residents to repatriate foreign dividends to South Africa.

Paragraph 64B of the Eighth Schedule to the Act provides that South African holders of shares are allowed to make a tax-free sale of foreign shares in a foreign company in which they hold an interest of at least 10% as long as that sale is made to a non-resident. The policy rationale for the participation exemption in this paragraph follows the notion behind the participation exemption in section 10B(2) for foreign
dividends in that:

  • the profits realised from the sale of shares represent unrealised dividends, and
  • such profits would in any event have qualified for the participation exemption in section 10B(2) for foreign dividends had they been declared as a dividend to the South African tax resident shareholder.

The concern expressed in the 2020 Budget Speech was that residents that hold shares in a resident company changing its tax residency could, subsequent to the cessation of its residency, dispose of its shares in that (now foreign) company to a third party and qualify for the participation exemption available in paragraph 64B in respect of any realised capital gain.This is especially relevant where where a controlled foreign company (CFC) ceases to be a CFC as a result of the disposal of all or some of the equity shares in that CFC.  Section 9H provides that the capital gain or loss realised in respect of such disposal is disregarded if the participation exemption under paragraph 64B applies.

This scenario can be illustrated where:

  • a South African tax resident company changes its tax residence to another tax jurisdiction (becoming a foreign company) or a CFC ceases to be a CFC, and triggers a deemed disposal of its assets in terms of section 9H of the Act on the day preceding its change in residency, and
  • after its exit, the South African tax resident shareholders dispose of the equity shares in the new foreign company and qualify for the participation exemption available in paragraph 64B in respect of the gain on disposal of the shares, even though the unrealised growth in the value of the shares occurred while the company was a South African tax resident.

This allows South African resident shareholders to benefit from a participation exemption on disposal of the shares in a non-resident company that was a resident company when the shares were acquired and is clearly against the intended purpose of the participation exemption.

It was therefore proposed that changes be made in section 9H of the Act in circumstances where shareholders trigger a dividends tax exemption for the company when a deemed dividend in specie is declared (on cessation of residency). The amendment deems those shareholders to have disposed of all their shares in the company at market value on the day before it ceased to be resident and to have reacquired the shares at market value on the day of the exit.

The proposed amendment will apply retrospectively from 1 January 2021 if passed in its current form and in respect of the holder of shares in a company that ceases to be a resident on or after that date.

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